Column: A little less lazy pragmatism, please

Written by Jahangir Aziz | Updated: Sep 20 2013, 10:07am hrs
There is some thing common between Ben Bernanke and Stan Fisher. Their policy choices have largely been driven by their academic research. The Feds monetary easingunprecedented in size and durationdid not come out of accepted central banking principles. Rather, it was from Bernankes academic work on the Great Depression and Japans near-permanent recession which argued that, in a crisis, liquidity cannot be drip-fed, it needs to be overwhelming. Since the late 1980s, Stan Fishers research has underscored the importance of monetary policy targeting inflation and keeping inflationary expectations under wraps. When the Bank of Israel raised interest rates, it did so aggressively such that it remained ahead of the curve ensuring that inflationary expectations remained anchored. So, when it was time to ease, the central bank found ample space to do so just as aggressively. Thats the story of Bank of Israels monetary policy in the last five years.

In India, we have largely abandoned basing policy and reforms on theory and empirical evidence. Instead, we have chosen to justify badly structured ad hoc policy changes on pragmatism and reality. We chose to change interest rates in gradual steps so that banks could adjust to these changes discarding three decades of theory and research that have consistently pointed out that the only way monetary policy affects the real economy is if banks cannot pre-empt the policy changes. The only time the market was truly surprised was when this July interest rates were effectively hiked 300 basis points one Monday night. But, almost immediately, RBI and the government undermined the rate hike through (perhaps unintended) administrative actions.

In the growth mayhem of the last three years, only the household sector managed to preserve its balance sheets by avoiding equities and real estate and investing in gold. Rather than laud the households for good judgement, we raised import duty on gold to lower the burgeoning current account deficit. But it wasnt a current account problem. It was capital outflow that just took the form of imported gold because households did not have any other safe asset to invest in. But, instead of raising the yield on domestic assets to make the capital stay, we took steps that could well impair the only healthy balance sheet in the economy. Todays economic policymaking framework looks like a kitchen sink of similar ad hoc policies justified on the grounds of pragmatism whose impact on the economy is plain to see.

One fervently hopes that Dr Raghuram Rajan will follow his other illustrious counterparts, eschew easy pragmatism, and instil in RBIs policymaking much-needed theoretical and empirical rigourin particular, rely on his work in banking for which he was awarded the first Fischer Black Award and on his economic history and political economy studies that underscore how incumbent interest groups strangle competition and growth.

One of the earliest ideas Rajan explored was whether technology determined a firms financial structure, and its corollary whether the structure of finance determined an economys industrial structure. This is not a trivial question as we are often made to believe that financial engineering can overcome any such mismatch. As it turns out, Rajan found the answer to both questions to be yes.

So, take a look at the discussion paper issued by RBI a week before the new Governor took office: the first proposal is to introduce differentiated bank licences because different types of investment require different types of financing, and therefore, different types of banks.

But what really earned Rajan academic accolades was a series of theoretical papers co-authored with Douglas Diamond that explored fundamental questions such as why the fragility of a banks capital structure is essential for its existence. Why bank runs need not be caused only because depositors suddenly need liquidity but result from increasing illiquidity of banks investments. Why banks (and countries) resort to short-term borrowing as investment turns illiquid. How localised liquidity shortages become systemic. How the wrong medicine, i.e. providing capital when liquidity is needed or liquidity when capital is needed, can worsen a crisis. The Diamond-Rajan papers rewrote the way we thought about these issues.

Why should we bother with such esoteric theories After all, in the rough and tumble of real-world finance, real women and men deal with real problems, not theories. Because as the history of the last hundred years shows (on which Rajan has also written extensively), policies made by insiders only end up protecting them more from outsiders making the system more inefficient and less contested. Only when policies are based on theory and empirics and not on the insiders insistence on pragmatism does market efficiency increase. Take another look at the proposals in the RBI discussion paper. It calls for bank licences on tap, deposit insurance, asset restructuring companies, and PSU bank consolidation reflecting largely what Rajan concluded in his 2008 report on financial reform A Hundred Small Steps. This is a great start, promising that RBIs policies will be less based on lazy invocation of pragmatism and more on analytical rigour.

Perhaps thats why Rajans decision on the first day of taking office to subsidise banks by providing them with FX hedge for NRI dollar deposits at below market price struck a discordant note. But the market applauded the subsidy and the rupee appreciated. Ironically, the same market, a few days earlier, had gone ballistic at the prospect of the Indian government subsidising hungry children (the Food Security Bill). I guess because subsidising banks is pragmatic and hungry children not!

The markets euphoria rests on the expectation that this subsidy could bring in $10-15 billion. Really Over and above the similar-sized NRI deposit redemption for this year Some have argued that the dollar funds will be leveraged by banks. So, dont worry if the actual dollar inflows are lower. Im not sure that banks have actually worked out what happens to the penalty to be paid on the leveraged funds if NRIs decide to withdraw earlier. Moreover, the same NRIs are expected to fund a significant part of the $8 billion planned quasi-sovereign dollar bond issuance and bank foreign borrowing. But NRIs might just turn generous despite US rates set to rise even more and the looming uncertainty of the 2014 elections. Stranger things have happened. Incidentally, the Brazilian real and the South African rand have appreciated more than the rupee since RBIs subsidy announcement.

How will Rajan set monetary policy Going by his reaction to the Feds quantitative easing (see his book Fault Lines or his speech at the BIS this February), he remains concerned about the harmful and often irreparable effects easy monetary policy has on inflationary expectations. Thus, one should brace for a hawkish policy stance. But in any event the next policy review will not be decided by Indias inflation trajectory. Rather by what happens to the rupee. In contrast to Governor Subbarao, Rajan believes that the rupee has been oversold so an easier monetary stance will have to await the currency stabilising at an appreciated level. Demands on RBI to boost growth remains and after the Fed obliged this week, the space to cut rates appears to have opened up. One only hopes that RBI will not be fooled by appearances again.

The author is chief Asia economist, JP Morgan Chase. Views are personal